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The hedge fund subscription process (i.e. placing investor money into the fund’s brokerage account for investment) is a basic process that may be slightly different for each fund based on a number of factors. Managers should make sure they understand the subscription process because investors may ask questions about the process and how the subscription amounts ultimately get into the fund’s trading account. This post will discuss the framework for how subscription amounts move from the investor to the fund’s bank and brokerage accounts.

Bank Accounts

We previously discussed items related to establishing bank accounts for a hedge fund structure. In general bank accounts will be established for the fund as well as the management company. Establishing a bank account for a fund will be required when a fund’s broker requires all subscriptions and withdrawals to come from/go to a “same name” bank account. Some managers may choose not to establish a bank account for the fund and simply have the prime broker deal with subscriptions, redemptions and fund expenses if their prime broker does not have “same name” requirements. For the purposes of this article we generally discuss the subscription process with respect to structures where there are bank accounts for each individual fund.

Fund Administrator

The subscription process will be different if the fund utilizes a full service administrator instead of a non-full service administrator.

Full Service Fund Administration

If a fund’s administrator deals with the subscription process as well as the general accounting and NAV calculations (usually referred to as “full service” administration), then the fund manager generally will not deal with the subscription process at all. Many times the “full service” administrator will actually establish (or work with the manager to establish) the bank and brokerage accounts and will dictate to the manager the subscription process. Usually in these circumstances the administrator will also act as a “second signer” to add a layer of protection to the assets. [Note: the “second signer” process essentially involves the fund administrator reviewing and approving all movements of money from the fund’s bank accounts. While this service has been around for a number of years, it has become more common post-Madoff.]

Non- Full Service Fund Administration

For fund’s which do not have full service fund administration, the manager will be generally responsible for accepting subscription amounts and then making sure the amounts are properly moved to the brokerage account. Generally the attorney will work with the manager to help the manager establish the proper structure and processes but managers should also discuss the process with the administrator to make sure all parties understand how the movement of subscription proceeds affect the calculation of the NAV.

Subscription Process in General

Generally the investor will wire the subscription amount to the fund’s bank account. In the case of individual investors, subscriptions may sometimes be made by check. Once the subscription amount has been credited to the fund’s bank account, it may either be wired to the fund’s brokerage account or it may sit there until the first

day of the trading period.* Either the manager or the administrator (as described above) will work with the bank and broker to make sure the subscriptions are correctly transferred.

* Note: there are a number of different issues which may arise at this point including situations where the subscription is placed in the brokerage account before or after the first day of the trading period, and whether the investor will receive interest on the subscription amounts prior to the amounts being transferred to the brokerage account. These issues should be discussed between the fund manager, administrator and lawyer prior to the fund launch.

Single Fund Structure – Domestic or Offshore Hedge Fund

In a single fund structure, whether the fund is located in the U.S. or offshore, moving subscription amounts is straight-forward. Investors will place assets in the fund’s bank account and then the subscription amounts will be wired to the fund’s brokerage account. Generally a withdrawal is processed by a wire from the fund’s brokerage account to the fund’s bank account and then by a wire from the bank account to the withdrawing investor. Depending on the broker, subscriptions and redemptions may be able to be effected directly between the investor and broker for credit/debit directly to the fund’s brokerage account.

Offshore master-feeder funds will have process similar to the single entity fund structure process. The general master-feeder hedge fund will have domestic taxable investors invest into a domestic feeder fund and offshore and non-taxable U.S. investors invest into an offshore feeder. Both feeder funds will then invest directly into the master fund which ultimately makes investments directly. A typical investment process might be: investors wire funds to the appropriate feeder fund bank account, the feeder fund then wires the subscription to the master fund bank account and from there the subscription amount would be wired to the brokerage account. As above, withdrawals would be processed in the reverse order.

Mini-master hedge funds are becoming more popular because of cost considerations. Additionally these structures can be easier to deal with from an operational perspective. In the basic mini-master structure there will be two fund entities – an offshore fund and a domestic fund. Then, like the traditional master-feeder structure, offshore investors and non-taxable U.S. investors will place their assets in the offshore feeder and U.S. taxable investors will place their assets in the domestic feeder. Domestic investors will subscribe to the domestic fund which will act as the “master” fund. From there the offshore fund will invest its assets in the domestic “master” fund, becoming in-essence an investor in the domestic fund. [Note: separate post on mini-master hedge funds to be coming soon.]

The above discussion is general – each fund structure is unique and there may be certain reasons why a specific fund may have a process which is different from the discussion above. Indeed, in many cases the administrator and broker may be able to handle subscription amounts which bypass the bank accounts or the feeder funds in master-feeder structures. In any event, the fund manager’s operational team should work closely with the administrator to develop processes to ensure that the subscription process is seamless. We have specifically not discussed offshore segregated portfolio companies or series LLC structures because these structures are unique and subscription processes may vary widely.

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Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and SEC/CFTC regulatory support to start-up and established hedge fund managers. Please contact us if you have any questions.

Bart Mallon, Esq. can be reached directly at 415-868-5345. Karl Cole-Frieman can be reached at 415-352-2300.

In March, Deutsche Bank’s Hedge Fund Capital Group presented a closer look at the current status of the hedge fund industry in its “2010 Alternative Investment Survey” report (see press release). The report focuses on responses from 606 investors. 42% of the respondents were Fund of Funds, 21% were asset management companies, 12% were family offices/high net worth individuals, and the remaining group consisted of corporations, foundations and endowments, insurance companies, investment consultants, private banks, and private and public pensions.

This article summarizes the 2010 outlook from investors and the increasing relevance of the seeding business. In particular, it presents the strategies being favored/disfavored, regional markets being favored/disfavored, predicted allocation amounts, and other information related to due diligence and reasons for investing in hedge funds.

For the most part, investors are optimistic about 2010 and money is flowing back into the industry. Strategies for this year reflect concerns about the lack of transparency and protection in uncertain markets in 2008 and 2009. Investors are making choices that ride on renewed confidence in the industry and that favor reduced volatility.

Investors

Investors Generally Optimistic for the Future

Investor sentiment about how the hedge fund industry will fare in 2010 has greatly improved. In 2009, 41% predicted net asset outflows of over $150 billion and 30% predicted outflows of over $200 billion. In contrast, 73% of investors surveyed this year predict net asset inflows of over $100 billion and fewer than 2% are predicting outflows. Consistent with those percentages, investors are also predicting a positive 2010 performance on the leading indices (S&P500, MSCI World, and MSCI EM).

Favored and Disfavored Strategies

Surveyed investors predict that some of the best strategies for 2010 are global macro, equity long/short, distressed, and event driven. In fact, equity long/short makes up the largest portion of hedge fund assets. 51% of investors plan to add assets to this strategy (an increase from 31% in 2009), 38% plan to maintain their assets in the strategy, and 5% plan to reduce assets. Event driven also performed very well in 2009 with 42% of surveyed investors now planning to add assets to this strategy and 41% planning to maintain their assets. Investor interest in merger arbitrage has also jumped greatly from 6% intending to increase exposure to 26% in 2010. While 29% of investors planned to reduce exposure in 2009, only 4% now seek to reduce exposure.

The strategies that are anticipated to perform the worst in 2010 include cash, volatility arbitrage, CTA, convertible arbitrage, market neutral, and asset backed securities. Market neutral was one of the worst strategies for 2009 when other strategies were bouncing back. The percentage of investors seeking to add assets to this strategy has decreased from 26% in 2008 to only 17% this year. In terms of cash allocation, only 3% of investors plan to increase exposure (a drop from 13% last year), 43% plan to maintain their assets, and a whopping 32% plan to reduce their assets.

Regional Allocations

Overall, investors predict that the Asia region (excluding Japan) will perform the best in 2010 and the Western European region will perform the worst. This year, 45% of investors plan to invest in Asian (excluding Japan) funds–a significant jump from only 18% in 2009. Interest in investing in Chinese and Japanese funds is high compared with other countries. The percentage of investors that do not plan to allocate to each country is 22% and 23% respectively. In contrast, 52% of investors do not plan to allocate in Russia, 44% do not plan to allocate in Eastern and Central Europe (excluding Russia), and 37% of investors do not plan to allocate in India.

Surveyed investors expressed a similar interest in the Emerging Markets, with 38% wanting to increase exposure, 38% wanting to maintain exposure, and only 6% wanting to reduce exposure. These findings are in response to the strong 2009 returns after a rough 2008 that saw many Emerging Market funds close. In contrast, investors anticipate the Western European region will not fare well–with 56% seeking to maintain their current assets, 23% seeking to increase exposure, and 12% seeking to reduce exposure.

Hedge Funds

Investors are increasingly investing in hedge funds. In fact, 76% of consultants surveyed indicated that their clients were increasing allocations to this investment vehicle. When asked what the main benefit of investing in hedge funds was, 68% of the investors surveyed indicated that hedge funds provide “better risk adjusted returns.” This benefit is particularly valuable in a volatile and uncertain market. “Diversification,” which was previously the number one answer, remains a close second.

Amount Currently Invested in Hedge Funds

Currently, over 50% of surveyed investors still manage less than $1 billion in hedge funds. The Hedge Fund Capital Group expressed concern about this figure, explaining that more than $1 billion AUM is often necessary to build the institutional infrastructure for greater investments and to perform vigorous due diligence. On the other side of the range, the number of investors with under $100 million invested in hedge funds is decreasing. The Hedge Fund Capital Group explains that these funds have likely simply shut down due to the economy and inability to attract institutional investors, pension funds, endowments, and other larger investors.

A majority of surveyed investors have track records of investing in hedge funds for longer than five years (only 17% have less than 5 years), with nearly all of those with 15 or more years of experience based in North America, compared with their European and Asian investor bases.

Hedge Fund Managers

Since 2008 and in part due to the market, investors have been reducing the number of managers they use. They have also started disfavoring portfolios that are too diverse due to the fact that due diligence requirements are now more costly and timely. In addition to reducing the number of managers investors place their money with, investors are also preferring to place their money in larger hedge funds with AUMs of over $1 billion. Those investors focused on managers with smaller AUMs are generally based in Asia or Europe.

Allocations

In 2009, most investors made 5-10 initial allocations. Those investors who made over 10 initial allocations in 2009 were concentrated in Europe–a total of 54%. But in terms of follow-on allocations, U.S. based investors led the pack, with 50% making over 30 follow-on allocations.

Redemptions

Despite generally positive performance last year, investors are continuing to make redemptions–the Hedge Fund Capital Group explains this as a result of those managers who have not performed during the market bounce or those that froze assets and their investors are only now able to begin redeeming. The investors that have made the most partial redemptions–30 or more in the last year, were primarily fund of funds and private banks. This finding is consistent with the perception that these investors are performance chasers.

Available Cash to Allocate

Compared with 2009, surveyed investors are generally holding less cash. 50% of investors are either fully invested or only holding 0-5% cash. But the good news is that 29% have 10% or more cash available for investment.

Following up on the previous findings, surveyed investors are confident for 2010. Those that predict they will be fully invested in the next six months increased from 18% to 21%. Those that predict they will hold 0-5% cash increased from 32% to 39%, demonstrating a goal of investing more.

Hedge Fund Managers

Challenges and Assessing a Manager

In terms of the biggest challenges investors faced in 2009 and 2010, “selecting and monitoring manager” posed the biggest challenge, with “lack of transparency” also ranking highly. This year, “investments frozen with a manager” was a new category and also ranked very high. When assessing a hedge fund manager, investors used to cite the 3Ps: performance, philosophy, and pedigree. While those qualities continue to be important, investors have increasingly focused on risk management and transparency. This reflects greater caution and less reliance merely on manager pedigree. Performance ranks first, risk management ranks second, and philosophy ranks third in terms of importance.

Length of Due Diligence Process

The due diligence process has gotten more costly and timely. For most investors–over 50%, need 3-6 months to conduct due diligence of a manager. This statistic is consistent over the last three years. The percentage of investors who can complete this in less than 3 months has increased slightly and so has the percentage of those who need 7-12 months.

Seeding Business

The institutionalization of hedge fund investing is making it increasingly difficult for new launches to attract investors. While a minimum of $50 million AUM was once sufficient, the critical minimum is now $100 million. Emerging managers are therefore increasingly turning to the seeding business “to overcome the hurdle of reaching the critical size to gain visibility and profitability.” 17% of the investors surveyed seed managers. The majority of seeders are U.S. based–59%, with 30% in Europe, 9% in Asia, and 2% in Australia. Funds of funds are the primary investors that seed, with asset management companies and high net worth individuals following.

45% of fund of funds seed managers, followed 26% of asset management companies and 17% of family office/high net worth individuals.

There are three seeding business models: (1) revenue split, (2) equity split, and (3) platform. Under the revenue split model, seeders provide capital in exchange for participation in management and incentive fees. Nearly half of seeders surveyed use this model. Seeders provide capital in exchange for equity ownership and generally take active partnership role under the equity split model. 19% of seeders surveyed adopt that model. Finally, under the platform model, established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for profit share. Only 9% of seeders surveyed adopt the platform model. Before a manager turns to the seeding business, it should consider the support offered by the seeder, including the form of operations, risk management, marketing, strategic assistance and business development, and compliance and legal support. In addition to providing funding, well-respected seeders can also provide reputational capital.

For the most part, the average seeding ticket ranges from $25 million to $75 million, with fewer under $10 million and even fewer greater than $100 million.

Consultants

6% of the surveyed investors consider themselves to be investment consultants. The findings show that there has been an increasing presence of such consultants in the hedge fund industry. These firms serve as the “bridge between investment managers and pension funds.” The largest percentage of the consultants’ client base is the family office/high net worth individuals, followed by government funds, and fund of funds.

Hedge fund investors are also more frequently turning to consultants to perform extensive due diligence. These investors do not have the resources to perform increasingly rigorous due diligence and rely on consultants.

Hedge fund databases are online databases that collect and publish information and performance results from hedge fund managers who list their fund. Usually these databases are open to accredited investors who subscribe to the website.

Aside from providing basic information on the hedge fund, including the name of the fund, the manager, and contact information, the database will usually include performance results, fees, and other additional strategy and structure information. The extensiveness of the listing, as well as the amount of funds available for viewing, depends on the database.

For hedge fund managers, databases serve as a way to obtain investors and publish their fund’s information to a wider audience. Most websites require that the manager update their performance reports on a monthly or quarterly basis, and the cost to both list and update information is free. Often there are also additional requirements for a manager to list a fund, such as a minimum track record or minimum length of active performance, but this also depends on the individual database.

We have compiled a list of popular online databases, which are listed below. Information on these databases will be updated appropriately as the websites’ policies and fees change throughout the year.

Fee Structure: $6,000 for annual subscription (Global); $4,500 (Hedge Fund); $3,500 (Single Manager); and accredited investors or those who work for an accredited institution can use the Barclay DataFinder for Free

Over the past week, I have attended a couple of interesting panel discussions on the hedge fund industry. At these events, one of the common themes was that the investment management industry is changing and hedge fund management companies need to make sure that operations are tight – this means that a management company should have developed and robust procedures for disasters including, as the article below indicates, pandemics. It is expected that this topic will become even more important if the impact of the H1N1 virus does not abate.

As the last several months have unfolded, one thing has become clear: the influenza A (H1N1) virus is not going away. After the initial panic subsided, fear and concern seemed to diminish even though the World Health Organization and U.S. Centers for Disease Control insist that the threat is not over. Now, nearly five months since the first case of H1N1 was reported in Mexico, a pandemic has emerged as predicted.

As of November 1, 2009, 199+ countries have reported laboratory confirmed cases of pandemic influenza H1N1 2009, including over 482,000 cases and 6,000 deaths (World Health Organization). U.S. health officials estimate that the virus could directly and indirectly affect up to 40 percent of the nationwide workforce over the next two years (Centers for Disease Control).

What does this mean for hedge funds? It is more important than ever to ensure a firm can and will remain functional if you are affected by a pandemic. Particularly, hedge funds must be mindful of the repercussions of the virus, as a decrease in staff could cause potential downtime.

Below are six essential pandemic response steps that firms need to undertake to ensure their businesses remain at peak performance, even if an outbreak occurs in the office.

Begin response procedures BEFORE a disaster strikes.

Organizational resiliency starts by strengthening your organization during normal business operations prior to a disaster such as a pandemic. It should not take a disaster to compel your firm to evaluate its business continuity and response processes. One should be in place long before disasters strike.

Identify who will serve as crisis leaders and be in charge of handling situational changes that may occur, including communication to other employees about response procedures and alternative site locations. An ideal crisis leader is someone who demonstrates good leadership skills during normal business operations and has experience dealing with crises. Typical crisis leaders are members of the senior management team (i.e. COO, CFO or Portfolio Manager). Firms must also ensure all employees are mentally and physically able to respond to changes, especially if they are telecommuting.

Also, certify that all employees are cross-trained within the organization; if there is a staff shortage as a result of a pandemic, employees will need to fill additional roles and responsibilities. Non-critical employees, including business development, accounting and research analysts, may be able to take larger roles and assist during a pandemic response phase.

Develop disaster / pandemic procedures based on a variety of scenarios.

Be proactive. As part of the planning process, create a list of potential scenarios and define your firm’s response strategies. Impact scenarios should include both potential internal and external occurrences.

For instance, what is your response if access to your office building is restricted due to extensive H1N1 exposure? How will you access your email, market data and portfolio management systems? Where will employees work and how will they communicate with colleagues and counterparties?

Externally, how will you operate if your prime broker or fund administrator contacts are unavailable? Being prepared will ensure your business operations continue seamlessly and without interruption.

An EAP provides assistance and access to counseling services for issues in and out of the workplace. In the event of a disaster, employees may wish to speak with a professional counselor to deal with any stress or negative emotions that have resulted from the event. If you cannot provide a physical counseling presence, provide a list of area clinics that offer comparable services. In advance, consider preparing educational materials that inform employees of the various stress indicators and reactions they may experience as a result of a disaster. If employees know that support is available prior to a disaster, it will mitigate panic and stress, and they will be better able to adapt to changes in their environment.

You should also inform employees about current sick leave and family support policies in the event that someone is forced to take an extended leave of absence.

In addition to developing and strengthening your EAP, you might also consider having upper management and emergency response team leaders partake in Critical Incident Stress Management (CISM) training, which will provide advanced preparation for responding to critical situations.

Test alternate site and remote access capabilities.

If a crisis situation is directly affecting your physical workspace or your employees, you must be prepared to provide alternatives. You may choose to move business operations to an alternate site where employees can go without risk. An alternate site would make sense for crisis situations that are confined to specific areas, such as natural disasters, outages or other situations.

In a pandemic situation – particularly if you have had any outbreaks of illness amongst your employees – you may choose to allow employees to work remotely. If this is a viable alternative, ensure ahead of time that you have adequate capacity and infrastructure to support multiple virtual private networks (VPN) and remote access capabilities. Confirm the number of Citrix licenses you have available; if there are not enough to support your complete staff, you may need to consolidate responsibilities.

Review your business response plan and procedures with team members and leaders.

Develop communication notification and escalation procedures for response team leaders and assign internal notification tasks to each leader. Identify if there are external business partners who need to be notified as well (i.e. investors, service providers, etc.). Assign a primary and secondary spokesperson in case the public needs to be notified, and ensure the spokesperson(s) has training and experience dealing with the media. If your spokesperson does not have training, now is the time to arrange for crisis communications training.
Test your pandemic response plan.

It is important to test your company’s response plan with leaders and response team members to ensure there are no glitches or obstacles in the event of a real disaster. Test internal communication strategies – from response team leaders to staff members. This can be done manually or through an automatic notification system. You can also send employees to work at the alternate site or to work remotely to ensure there are no technical issues that can affect productivity. It is imperative that the teams and employees are able to work together and build trusting relationships today. A strong foundation that includes good performance and trusting relationships will enable your business to recover from any kind of crisis.

Business Continuity Professionals say that “planning” helps mitigate panic and downtime. It takes work and resources to develop a resilient organization prior to an interruption or disaster, but it is imperative if businesses want to stay operational. Businesses cannot function without employees that maintain knowledge and expertise to operate the business, and those employees need to know what to do during an interruption or disaster. Without a plan, you will spend the entire time chasing the incident instead of recovering from it.

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Operational Issues and Failures). Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets). In certain situations hedge fund audit firms will be engaged to perform an “Agreed Upon Procedures” review of the pricing of these assets. As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets. It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits. The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).

Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.

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Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator‘s role in relation to security valuation. We will, of course, return to this topic – but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today’s administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments. (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from “comparable” securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)

This leaves investors with a challenge – if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument. It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments – assuming the administrator has washed their hands of the problem – are third party pricing agents and auditor agreed upon procedures, or “AUP”. We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client. The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation. The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund’s pricing on a quarterly basis. This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags. Firstly, many AUP only test a sample of prices, not the whole portfolio. Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a “sample” basis???)

The bigger problem, however, is the type of testing completed by the auditor. In way, way too many cases, the auditor tests security prices back to the manager’s own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors. If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low? Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager’s own pricing file, how does the auditor know that those pieces of paper are genuine? As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis. A full, GAAP audit review is, of course, performed at year end – this does include independent pricing (although – investor fyi – auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud. In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point. Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance? Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here. The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular. Per the standard, a client requests an auditor to complete AUP to assist “specified parties” to “evaluate subject matter or an assertion”. In our case, the assertion would be “are hard to value securities valued correctly at quarter end.”

However, the specified party is usually the manager itself, making the client and specified party the same person. The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place! However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are “sufficient for their needs”. So, even if the investor believes that the AUP are not “sufficient for their needs” – which is hardly a long stretch – the investor has to sign that the procedures are sufficient if they are to even see the auditor’s work. With this magic piece of paper, the auditor has met its requirements and can sleep easy. Meanwhile, the auditor will send a bill to – guess who – the fund, meaning that investors have, once more, had to foot the bill.

Clients are demanding that investment managers communicate more than just data

The following white paper was released by BK Communications Group, a company which provides outsourced marketing and client communications solutions for the asset management industry. According to a recent survey of institutional hedge fund investors, clients largely prefer that managers take the call for transparency one level further and communicate to them in a meaningful way that explains what they’re doing with the funds. Popular forms of communication adopted by investment firms include pitch-books, websites, and personal contact. According to a report by McKinsey & Co., providing full transparency and enhancing communication efforts can be useful in client retention and future asset gathering.

The executive summary and highlights of the paper is re-printed in full below as well as a link to the paper.

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BKCG White Paper
June 2009
The New Transparency: Words

Clients are demanding that investment managers communicate more than just data

Executive Summary

Transparency has typically been equated with access to data (trade, exposure, valuation, etc.), but the financial crisis and fund scandals have led clients, investors, as well as regulators to demand more. Major surveys and anecdotal evidence indicate communication is now in demand. Clients want managers to put the numbers in context, to explain what they’re doing, to communicate on a clear and meaningful basis. This expanded transparency can help retain clients and strategically position a firm for future asset gathering, both by building a brand associated with full transparency and by ensuring that all touchpoints – from pitchbooks to websites to personal contact – are fully in place and high quality. Investment firms must carefully examine how they currently communicate, decide on any adjustments that must be made, and determine whether they have the internal capabilities and resources to execute on those adjustments.

Highlights

Communication is the new transparency. Data alone is no longer sufficient. Clients want managers to put the numbers in context, to explain what they’re doing, to communicate on a clear and meaningful basis

Preqin’s survey of 50 institutional hedge fund investors finds that events of the past 12 months have led 43% of respondents to expect “increased transparency and understandable strategy.”

Providing full transparency can be a way of helping to retain clients and strategically position a firm for future asset gathering. McKinsey & Co’s major report (“The Asset Management Industry in 2010”) concludes that “winning asset managers will be those who forge a superior reputation and capabilities for service and sophisticated advice.”

Communications transparency can be approached strategically, to ensure an investment firm’s brand is associated with openness and clarity, and to establish a reputation for thought leadership, as this is associated with mastery of core competence.

Communications transparency can also be approached tactically by making sure that all touchpoints – from pitchbooks to websites to personal contacts – are fully in place and high quality.

Many investment firms are shedding internal resources that are not profit centers, including communications personnel, or are hesitant to bring on those resources – leaving them without the necessary skills, or bandwidth, for an appropriate level of communications.

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Auditors). Today we are publishing a press release which announces a new white paper from Castle Hall detailing the various reasons which hedge funds fail. The press release also describes a new web database called HedgeEvent which was created by Castle Hall and details a number of hedge fund operational failures over the last few years.

I found the white paper to be interesting. I would imagine that some fund of funds and other types of hedge fund investors would find the information useful. A couple of interesting facts from the whitepaper:

The most common causes of operational failure in hedge funds are (i) theft and misappropriation and (ii) existence of assets (i.e. Ponzi schemes).

Long/short equity and managed futures are the strategies which are most likely to be subject to operational failure.

MONTREAL–(BUSINESS WIRE)–Castle Hall Alternatives, the hedge fund industry’s leading provider of operational due diligence, today published its latest White Paper, ‘From Manhattan to Madoff: the Causes and Lessons of Hedge Fund Operational Failure.’ The Paper’s analysis and findings are based on HedgeEvent, a comprehensive, web-based database of more than 300 operational events, now available to Castle Hall’s due diligence clients. HedgeEvent supplements HedgeDiligence, the firm’s existing client web portal.

The White Paper may be downloaded from www.castlehallalternatives.com/publications.php

Chris Addy, Castle Hall’s CEO, said “the colossal fraud perpetrated by Bernie Madoff, together with a number of other recent cases, has made investors acutely concerned by the risk of operational ‘blow ups’. However, there has been little systematic study of operational failure, meaning that investors have limited guidance as to the extent of this problem.”

“The creation of HedgeEvent, which has taken more than two years to compile, has enabled us to summarize key metrics related to hedge fund operational failure” said Addy. “From Manhattan to Madoff analyzes operational events by number, estimated loss, causal factor and by the strategy of the funds involved.”

HedgeEvent contains 327 cases of hedge fund operational failure through June 30, 2009. Madoff, with an estimated financial impact of $64 billion, is by far the largest; the remaining cases have an aggregate estimated financial impact of approximately $15 billion. Of the 327 operational events, 121 have an estimated impact of $10 million or more, and 31 of at least $100 million.

“While operational failures are material – Madoff spectacularly so – it does not seem that fraud is pervasive in the hedge fund industry” said Addy. “Investors should, however, be very focused on the lessons which can be learned from those hedge funds which did generate large losses. Many of these were well established firms which attracted capital from reputable investors.”

Across all Events, the most common causes of operational failure are theft and misappropriation followed by existence of assets (the manager claimed to own fake securities or operated a Ponzi scheme where reported assets did not exist). The most common strategies subject to operational failure are long / short equity followed by managed futures. It is notable that investors have traditionally viewed these strategies, holding largely exchange-traded securities, as straightforward with low operational risk.

“HedgeEvent is an invaluable tool for both Castle Hall and our clients” said Addy. “A lot can be learned from historical events: better knowledge can help investors avoid the losses, both monetary and reputational, of hedge fund operational failure.”

About Castle Hall Alternatives

Castle Hall Alternatives helps leading institutional investors, fund of funds, family offices and endowments identify and manage hedge fund operational risk. Castle Hall’s team draws on more than 30 years of direct due diligence experience and is the industry’s largest, dedicated provider of operational due diligence. More information is available at www.castlehallalternatives.com

It is nice to have a chance to step back from the regulatory side to see the big picture of the hedge fund industry. The article below discusses what is currently happening in the various hedge fund strategies and what investors are looking for from managers. The article is written by Bryan Goh (First Avenue Partners) and addresses the issues related to the hedge fund industry in June of 2009. Reprinted from Byan’s blog called Ten Seconds Into the Future.

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Hedge Funds: The State of the Craft: June 2009

By Bryan Goh

The fundamental picture:

The second quarter of 2009 witnessed a continuation of the rally in all risky assets from equities to credit to commodities and energy to illiquid Asian physical real estate. On the back of this reversal of the acute risk aversion that plagued the fourth quarter of 2008 and the first quarter of 2009, economists began to detect ‘green shoots’ of economic recovery. However, economic growth forecasts in the developed world continue to be depressed. The US for example is expected to show -2.8% growth in 2009 with a weak recovery in 2010 of 1.6%; the Euro zone is expected to shrink by 2.3% in 2009 and grow by an insipid 1.7% in 2010 with dire numbers from Germany (-5.5% 2009, +0.55% 2010), and Italy (-4.4% 2009, +0.4 2010). Emerging markets were widely expected to decouple, but thus far the incipient recovery is only evident in BRIC, with China growing +6.5% in 2009 and +7.3% in 2010, India growing +5.5% in 2009 and +6.4% in 2010, Brazil shrinking 1.5% in 2009 before growing 2.7% in 2010 and Russia shrinking 5% in 2009 and growing 2% in 2010. Outside of the BRIC, emerging markets’ highly export driven economies are severely impacted by the slowdown in the developed world, the dearth of demand and the unavailability of trade finance.

Developed markets have been hobbled with historically high debt levels, distressed real estate prices, rising unemployment, weakening retail sales, shrinking industrial production and declining consumer and business confidence. Coupled with impaired sovereign balance sheets, the result of financial rescue packages, Keynesian fiscal reflationary policies, an ageing population’s impact on state pensions and healthcare, the outlook for developed market growth is not optimistic. The one area of potential respite is the external sector, which as a matter of mathematics has to and will adjust to reduce the scale of current account imbalances.

Emerging markets have somewhat healthier financial systems, sovereign balance sheets and private savings levels and are thus in a better position to implement fiscal reflationary policies and centrally influenced if not planned extension and allocation of credit. This, however, remains concentrated in the larger emerging markets such as BRIC where domestic diversification reduces the dependence on the external sector.

The expansion of the government in the economy is therefore more feasible in the BRIC. It has been moderately successful. China is a case in point where fixed capital formation in the form of infrastructure build has more than made up for the gap from a collapse of external trade and a moribund consumer sector.

These efforts provide a stay of execution. Time, however, is a healer, under the assumption of free markets. Protectionism and outright central planning has historically proven counter productive. It is interesting to note that while developed markets flirt with market interventionist policies, bend Chapter 11, and increasingly embrace quantitative easing, further emergency interest rate policy, flirting with protectionism, interfering with the banking system; emerging markets have by and large embraced free markets.

While policy makers continue to hold interest rates at low levels, the inflation deflation debate continues. Central banks with formal inflation targets may be more likely to tighten prematurely than central banks with a softer target or a more holistic mandate. Given the rate at which capacity utilization has fallen and the current levels at which it rests, it is unlikely that inflation will take hold. On the other hand, given the reflationary capacity of BRIC and competition for natural resources, deflation is unlikely to take hold either. Central banks are likely to be afforded the latitude to hold short rates lower for longer in their anti-recessionary campaigns. Long bond yields are likely to display news driven and data driven volatility as signs of inflation wax and wane.

Hedge Fund Performance:

Performance to May 2009:

Hedge Fund Outlook:

Generally, the outlook for hedge fund strategies is very positive. There are a number of reasons for this. The period 2005 to 2007 saw a surge in equity capital employed in hedge fund strategies. With increasing volumes of arbitrage capital, return on gross capital employed compressed, as one would naturally expect. Hedge funds adaptively increased their leverage in order to maintain return on equity, a strategy feasible because interest rates were low and credit spreads were tight and thus leverage was cheap. The bankruptcy of Bear Stearns and then Lehman Brothers in 2008, triggered a massive deleveraging of the entire arbitrage industry from hedge funds to bank proprietary trading desks. Mark to market losses triggered large scale redemptions from hedge funds which left what in 2007 was a 2 trillion USD industry with an estimated paltry 1.2 trillion USD of assets under management. This together with the wholesale withdrawal of leverage from an average of 3.5 to 4 X to 1.5 to 2X, implies a 70% to 75% shrinkage in capital employed in arbitrage. The indiscriminate withdrawal of risk has created ubiquitous arbitrage and relative value opportunities.

Equities: Market sentiment went from monotonic risk aversion from the second half of 2009 into the first quarter of 2009. During this time, equity dispersion was explained not by earnings prospects but by news flow and macro implications on balance sheet integrity. And a great deal of simple panic. The very sharp rebound from mid March 2009 has similarly been driven not by earnings fundamentals but by a reversal of risk aversion and other dynamic factors. As market volatility settles, equity dispersion is expected to be increasingly driven by fundamentals once again. The opportunity set for equity long short managers is improved.

Event driven: In every distressed cycle, private equity buyouts dwindle and deal break risk is escalated due to buyers remorse. When coupled with a credit crisis, jurisdictions where committed financing is not a prerequisite to an approach and banks themselves in jeopardy also increase deal risk. Following this initial round of panic and disorder, the following period of calm usually witnesses deal flow on the basis of strategic alliance, self preservation, consolidation, asset disposals, and capital raising. This is the landscape facing the event driven merger arbitrageur today. The dearth of arbitrage capital has also resulted in slower convergence, more volatility of spread and a profitable environment for the strategy.

Macro and Fixed Income: Macro strategies did relatively well in 2008 as large and trivial trades presented themselves with the ebb and flow of capital driven by acute risk aversion and government reactionary policy. These trades have now receded into history. Going forward macro is likely to continue to perform well on the back of persistent volatility in fixed income markets driven by the cycles of central bank policy and investor prevarication between inflation and deflation. These same themes create interesting arbitrage opportunities in fixed income arbitrage as well as short rates react to policy and long rates to inflation expectations and sovereign credit risk. The reduction of capital in fixed income arbitrage also presents interesting arbitrage opportunities between cash, synthetic, futures, forwards, swap and repo markets.

Asset based investing / lending / Trade Finance: The global credit crisis and associated global economic recession has resulted in a dearth of credit. Providers of credit are therefore well rewarded. In trade finance, for example, a sharp fall in world trade of over a third in the final quarter of 2008 was only surpassed by the contraction of available trade finance. Banking consolidations also constrain credit further as obligor limits are exceeded in merged financial institutions. The result is wider spreads and tighter collateral terms. Hedge funds involved in lending are able to use non-traditional deal structures to secure their collateral while exacting competitive spreads.

Credit: A situation in credit markets exists akin to the one in equities. Systemic risk was high in 2008 and credit was systematically sold despite differentiated idiosyncratic issuer risk. The credit space is richer than equities, however, due to the richness of the capital structure, particularly in more mature developed markets like the US, representing excellent raw material for which to express capital structure dislocation trades. Differing natural investors or traders at different parts of the capital structure create arbitrage opportunities which barring unilateral regulatory or government intervention, represent true arbitrage.

Convertible arbitrage: Convertible arbitrage was one of the worst performing strategies in 2008 and one of the best performing strategies in 2009 to June. The losses came from a confluence of general risk aversion, deleveraging by banks and institutions, hedge fund redemptions and failures from over-levered portfolios, and a collapse in the funding mechanism of which the prime brokers were integral. With a normalization of market conditions convertible bond markets have recovered sharply. The crucial question is, to what extent is the current recovery in convert arbitrage funds purely a directional one, profiting from the rising tide lifting all boats. Convertible arbitrage, however, is a catch all for a suite of sub strategies of varying sophistication, direction and use. The current market is replete with less-directional opportunities. These arise from the diversity of pricing and valuation across the convertible space, as well as a revival in primary issuance. The credit elements of convertible arbitrage were highlighted in 2008 and will continue to be a key consideration in assessing convertible bonds. Directional expressions of fundamental views on companies can be very efficiently captured using convertibles as well. A fundamental view on a company need not be restricted to first order (levels) pricing but can extend to views about the pricing of the volatility of the company. Capital structure trades can also be expressed with convertibles for example in theoretical replications with bounded jump to default values for a range of recoveries.

Distressed Credit: When the credit crisis first broke in mid 2007 in the US sub prime real estate mortgage market, investors had already begun to seek opportunities in distressed debt. The distress has been concentrated mostly to the real estate backed securities market and latterly to consumer loan backed securities. Among corporate rated issuers default rates remained low. High yield default rates while accelerating sharply in 2008 had only reached 5.42% by 1Q 2009 according to S&P. S&P expects the default rate to climb to a peak of 14.3% in 2010. Distressed debt managers returns tend lag default rates and accelerate when default rates have peaked. A three to four year period of outperformance is usually measured from the peak of the distressed cycle. This is consistent with the bankruptcy processes of the developed markets such as Chapter 11 in the US. The risk remains that the economic recovery will be an insipid one and or that the economy may sink back into recession before it finds a stable trend path. Distressed debt managers also tend to be weakly correlated at the peak of the default cycle and maintain low correlation for about 3 years after which correlation creeps into their returns.

The events of 2008 have resulted in a peculiar situation where almost every hedge fund strategy is likely to perform well going forward. This is not to say that there is little or no risk. The choice before the investor remains the magnitude and the type of risk they are happy to assume. In liquid strategies such as equity long short, the risk is non-convergence, for there is often no functional relationship to bring relative value trades in line. For strong convergence, such as capital structure arbitrage strategies, convergence is less uncertain, at maturity or in default. However, under going concern assumptions, spreads can be volatile and can widen significantly and sometimes unpredictably. There is a trade off between market risk and liquidity risk.

At various times, the opportunity has shifted from asset class to asset class, from strategy to strategy, requiring a careful portfolio construction to capture the appropriate risk reward characteristics of each strategy, while achieving efficient portfolio diversification. Under current conditions, when risk reward properties of almost every strategy are favourable, the portfolio construction problem is significantly simplified.

Investor Risk Appetite:

In the first half of 2008 investors were content to be worried about their hedge fund allocations while remaining invested. Recall that for the year up till June 2008, hedge funds had turned in a moderately poor (-2.43%) performance. It was only when the losses accumulated and large regulated insurance companies and banks either went bankrupt or threatened to do so, did hedge fund investors decide to redeem in any size. The Madoff fraud further destroyed the trust between investors and their fund managers leading to the demonizing of the entire hedge fund industry not only within the industry but in the general medial as well. Redemptions crescendoed in March 2009 while hedge fund managers, some with liquidity mismatches or funding issues, began to restrict or suspend redemptions in an attempt to avoid disposing of assets at firesale prices.

Hedge fund investors’ reaction, quite understandable began with complacency in early 2008, to fear and panic in 3Q 2008 to despondency in 4Q 2008 and 1Q 2009. The rebound in markets and hedge fund performance took most investors by surprise.

As recently as April / May 2009, investors’ risk aversion remained acutely high. From early June 2009 this has changed somewhat as investors have begun to scout for opportunities in the hedge fund space. A number of things have changed since 2008. For one, investors will no longer tolerate liquidity mismatches, and while the immediate reaction has been to demand liquidity and favour liquid funds, a more discerning investor base is now analysing portfolio and strategy liquidity and requiring fund terms to better reflect the underlying liquidity.

The area of hedge fund fees has also come under scrutiny. While a number of funds have discounted their fees, it is unclear if there is any price elasticity. Price elasticity appears to be a weak factor compared with other factors such as manager quality, rational liquidity terms, transparency and operational integrity. In the area of fees, more sophisticated fees seem to be emerging which seek to better align investor and fund manager interests over a rolling investment horizon instead of the current annual fee crystallization which creates cyclicality in manager behaviour.

Transparency has become the most important issue for investors. Without transparency, due diligence and ongoing monitoring is blunted, style drift and frauds go undetected. Transparency goes beyond, and sometimes around, position level disclosure. More constructive forms of transparency include risk aggregation reports, sometimes sent by the fund administrator, periodic calls with the portfolio manager, periodic portfolio detail. The periodic preference for managed accounts has once again re-emerged. Quite whether it is sustained remains to be seen, but managed accounts while useful in some respects is no panacea.

As hedge funds react to investor needs, a stronger industry will arise, albeit initially a smaller one. It is hard to see growth rates regain their heights in 2007. However, given the relative outperformance of hedge funds versus long only equity, credit fixed income, commodities and real estate both in 2008 and over a 10 year period it is easy to underestimate the growth of the industry.

There are a few common topics which have been coming up lately in my conversations with managers. Of these probably the question of greatest interest deals with what sort of fee structure investors are looking for right now and what kinds of fee concessions are manages granting to investors. In the article below Bryan Goh (First Avenue Partners) addresses these issues and shares his thoughts on the hedge fund industry after a recent conference. This article was reprinted from Byan’s blog called Ten Seconds Into the Future by Bryan – I highly recommend this blog for all hedge fund managers. [Another blog I highly recommend is Compliance Building by Doug Cornelius. This blog will be a great resource for anyone interested in issues involving compliance issues.]

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The month of June is replete with hedge fund conferences. Conferences earlier this year were either poorly attended, or else investors attended them for the free breakfast or lunch, a chance to commiserate with fellow sufferers of the global financial crisis/hedge fund witch hunt. What a differences a couple of months of rising markets make.

I recently attended the Goldman Sachs European Hedge Fund conferences held in London a couple of days ago. Over 50 hedge fund managers attended to present their funds and a rough count of what must have been over 300 investor groups showed up if not to allocate soon then at the very least to window shop.

The quality of managers was in general very high. Perhaps the weaker managers had been washed out or were facing legacy issues and thus not investable, there was clearly a Darwinian dynamic at work. The organizers would have been very selective as well so as not to waste investors time. Or maybe it was just that Goldman Sachs simply had a bigger client base and could move further into the right tail of quality. Or, dare I say it, Goldman’s clients were of a better quality. I don’t know, all I know is what I saw. 5o over managers, all to a greater degree, investable if one was so inclined to their strategies.

Many established managers previously closed to new investment, or usually reluctant to be presenting at capital introduction events were presenting. Only recently, Israel Englander’s much vaunted Millennium was out looking for new capital at a number of conferences around the globe. These managers have experienced outflows of capital, redemptions which may be uncorrelated to the quality of their performance in 2008, and find that they have capacity to replace this exiting capital, as well as are faced with rich opportunity sets upon which to capitalize and thus have improved capacity.

Panel upon panel of strategy specific discussions were held and all well attended. Investors were clearly looking for new ideas, a sign of recovering risk appetite and the need to put capital to work. In every discussion, the macro landscape was an issue of great importance. At each panel, regardless of the uncorrelated or non-directional nature of the strategy from event driven to market neutral strategies, moderators and panel members were clearly focusing on the macro landscape, on regulation, on government intervention, and how these would impact the functioning of markets in which they invested. One thing was clear, there was no consensus as to the health of the global economy. Goldman Sach’s Head of Global Economic Research Jim O’Neill was of the opinion that the worst was over and that a V shaped recovery was underway. His team forecasts better than expected growth from economies like the BRICs driving global growth. Hedge fund manager’s, however, were almost evenly split 50:50 between bulls and bears, with the bears with the slight edge in extra time. Student’s of Murphy’s Law and other dynamic system theories will tell you that this is a healthy balance and likely to prolong current trends whether rising or falling and that reversals occur when the balance is jeopardized one way or the other.

What was really interesting for this observer, was that despite the lack of consensus over economic growth and market direction, each manager saw immense investment opportunities in their own particular strategies and markets. This would appear to be an inconsistency at best and more cynically, disingenuity at worst. Not so, in my view.

Of all the strategies represented at the conference, there was consensus among the respective manager groups, that the opportunities for profit generation were great. Equity long short, Distressed Debt, Merger Arbitrage, Volatility, Multi Strats. They all saw ways that they could make money, yet none of them could agree on whether the economy had stabilized, whether growth would resume or falter, whether inflation would rise or sink into deflation, whether markets would rise and fall. There is a larger lesson for students of economics, but that is not our aim here.

One can argue that macro leads micro, I’m not quite sure how yet, but in the narrower context of this discussion, micro leads macro. What these managers are individually telling us is that there are micro strategies that can be profitable. A macro analysis of the strategies that these managers employ will simply not be granular enough to capture the opportunities they talk about. And yet, when sufficient numbers of them make money, when sufficient capital is put to work in these opportunities, the macro structure of the trades becomes evident. This is the natural evolution of strategy.

Fees and Terms:

The industry has been debating if there has been any fee compression in the wake of the financial crisis of 2008, and hedge funds’ apparently failure to perform as advertised. I have defended the performance of hedge funds through the initial stages of the crisis, but that is the subject of another discussion. At the Goldman conference, there was definitely a growing number of managers charging less than the usual 2 and 20. 1.5 and 15, and even 1 and 10, fees were seen. Encouragingly, I met a handful of managers who were either considering or in the process of establishing a holdback provision with a vesting period, on performance fees, whereby a portion (say 50%) of a year’s performance fees are held in escrow and a negative performance fee is applicable to the amound held back.

Liquidity terms were also a lot more logical. Illiquid strategies did not shy away from lock ups, while well performing or big name hedge funds with liquid portfolios and strategies, passed on that liquidity to investors. Some managers went as far as to formally exclude so-called gates, restrict suspension of NAV rights to specific circumstances, and specify side pocket provisions more explicitly. It appears that the events of 2008 have precipitated a much welcome self regulatory campaign.

Strategies:

Equity long short managers were in abundance, naturally, given their market share of the hedge fund industry. The diversity of styles within what many consider a relatively simple strategy makes it a very interesting area to analyse and invest. There are managers who are driven by the philosophy that fundamentals, that is earnings, cash flow generation, financial strength, matter most in determining valuations. There are those who are traders, for which fundamentals are secondary, and what matters most is how a stock’s price has behaved and is behaving. Still others, have a macro or thematic approach, and apply these to equity investing. The trading style managers were bullish, arguing that increased volatility and dispersion in equity returns represented opportunity for profit. It also represents opportunity for loss as well of course. Alpha can be negative. Some of them were bullish on the market, some were bearish on the market, but there was general enthusiasm for the opportunity to trade. Fundamentally driven stock pickers were similarly upbeat about their strategy, arguing that the last 6 months have seen a wholesale disposal of risk followed by in the last 6 weeks, a reversal of this risk aversion, and that such large systemic moves create mispricings in individual companies which they seek to exploit. As always there were some very clever approaches to equity long short. There was a manager who had a very strong macro view, and invested a lot of time in macro research, then researched company fundamentals in an attempt to understand the impact of macro developments on company fundamentals. There was another manager which analysed only audited financials and ignored all street and interim data, and then built sophisticated models to obtain their own interim numbers. All these various managers had credible reasons why their approaches would work. In 2005, I would not have believed them; today I am a lot less skeptical.

Convertible Arbitrage managers were conspicuously absent from the conferences. The best performing strategy in 2009, albeit the worst performing strategy in 2008, convertible arbitrageurs were too busy making money from the market to attend a capital introductions event. Moreover, who would listen, they would argue, most investors having being burnt in 2005 and then again in 2008. There are good reasons why the strategy is working and is likely to work further, but the managers were too busy working it than selling it. Good for them.

Distressed Debt has been a preferred strategy since late 2007. That, however, was an expensive false start. By the end of 2008, with insufficient defaults and a catastrophic dislocation in credit markets from LIBOR to swaps, from ABS to corporate, from cash to synthetics, distressed debt managers had suffered considerable losses. Rational, no memory investing would have suggested getting back into distressed investing in 2009 and to their credit, investors have been bullish on distressed investing once again. A number of surveys taken in 1Q 2009 ranked distressed investing as one of the top 3 hedge fund strategies among investors for 2009.

One of the least favored strategies, if investor survey’s are to be believed, is merger arbitrage. It may surprise one to learn that on a rolling 12 month basis, merger arbitrage has been one of the best performing hedge fund strategies, behind global macro and CTAs. Merger arbitrage, or risk arb, was well represented at the Goldman conference and it was clear that risk arbitrageurs were very much excited about the opportunities before them.

Since July 2008, M&A transactions numbered over 5000 representing over 1 trillion USD in value, and deal flow continues on the back of cashed up corporate buyers seeking strategic assets, distressed sales from corporate restructurings, distressed sellers and government interventions. Company’s are happier to do deals in rising stock markets and easing financing conditions. Also, BRICs and other EM markets outbound transactions have been strong and remain an area of considerable potential growth.

Deal spreads have been volatile. The dislocation of markets in 2008 represent a stepwise repricing of an over arbitraged space. Deal spreads of circa 10-11% blew out to 50 – 60% before settling at current levels of 15 – 20% IRR.

The financial crisis of 2008 has also reduced the number of participants leading to a much less crowded space. Bank prop desks have exited or significantly reduced their books and hedge fund capital dedicated to risk arb has shrunk more than proportionately to the industry. Many risk arb funds drifted into a much too early play in distressed credit as quite often the resources if not the skill sets are the same. M&A very often wanders into litigation and distressed investing is very much about litigation. While a pure risk arb strategy would have done relatively well in the last 12 months, the contamination from a catastrophic credit strategy has hurt many multi strategy funds with large risk arb books resulting in poor performance and redemptions. The reduced capital employed in risk arb not only results in wider deal spreads but allows more time for analysis and deal selection leading to more selective participation.

A renaissance for hedge funds:

Since hedge fund indices have been compiled, that is 1990, until the present, with the exception of 1998 and 2008, hedge funds have steadily generated positive absolute returns. These returns have seen varying correlations to the returns of other traditional asset classes such as equities and bonds, as well as varying information ratios over time. From 2005 to 2007 hedge funds’ returns exhibited increasing correlation to traditional asset classes, decreasing returns to invested capital, increasing inter strategy correlations and increasing leverage. These features are interrelated and are directly related to the amount of capital dedicated to hedge fund strategies.

With more capital deployed in arbitrage and relative value strategies, continuous risk was more evenly distributed, volatility was dampened, volatility of volatility and correlations was also dampened, credit spreads converged, other arbitrage and relative value spreads also converged. The only way to maintain return on equity was to increase the level of leverage, a practice eminently feasible in an environment of cheap credit. Return on capital at risk, however, compressed to unsustainably low levels.

Such periods of calm accumulate imbalances for discontinuities. It would seem that a protracted reduction in continuous risk results in an accumulation of gap risk. In 2008, that gap risk was crystallized resulting in a discontinuous reduction in systemic leverage and thus capital employed in arbitrage and a concomitant system wide widening of arbitrage and relative value spreads.

This is one of the more plausible explanations for why, in an economy clearly in decline, with recovery highly uncertain and non-robust, with differing opinions and outlook for financial markets, arbitrageurs are optimistic about their profit generation potential across almost all, if not all, hedge fund strategies.

Arbitrageurs will be required once again to police arbitrage and relative value spreads to bring convergence to no-arbitrage pricing, to bring relative value valuations in line and to aid in the efficient allocation of capital. In a sense, and to a certain extent, the real economy is reliant on the arbitrageur in the healing process, and therefore, one factor for the rate of recovery, or repair, of the real economy, will be the rate at which capital is redeployed to take advantage of mispricings and other arbitrage opportunities.

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Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

In what represents an unbelievable screw-up, professed hedge fund due diligence firm Hennessee Group was charged by the SEC with not performing the due diligence it supposedly provided to hedge fund investors who used their services. According to the SEC Administrative Order, Henessee did not perform certain key elements of the due diligence process which they advertised to potential clients. Because of the lack of due diligence, Henessee recommended investing into the fraudulent Bayou hedge fund.

A few of the more interesting parts of the release include the following:

From February 2003 through August 2005, approximately forty clients of Hennessee Group invested a total of over $56 million in the Bayou funds after receiving Hennessee Group’s recommendations. Most of those monies were lost and dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements, periodic newsletters, and year-end financial statements that included a phony audit opinion fabricated by one of Bayou’s principals.

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Hennessee Group and Gradante, in their capacities as investment advisers, owed fiduciary duties to their clients to perform the services that they represented they would provide and to disclose all material departures from the representations that they made to their clients. Despite their representations about their services, with regard to the Bayou Funds and the funds’ management, Hennessee Group and Gradante did not perform two of the five elements of the due diligence evaluation that they had represented to their clients they would undertake. In addition, Hennessee Group and Gradante failed to adequately respond to information that they received that suggested that the identity of Bayou’s outside auditor was in doubt and that there existed a potential conflict of interest between one of Bayou’s principals and its purported outside auditor.

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With regard to Bayou, Hennessee Group, at Gradante’s direction, failed to perform two elements of the due diligence evaluation that Hennessee Group had told its clients and prospective clients that it would do: (1) a portfolio/trading analysis; and (2) a verification of Bayou’s relationship with its purported independent auditor. By not conducting the entire due diligence evaluation that it had advertised, and by failing to disclose to clients that its evaluation of Bayou deviated from its prior representations, Hennessee Group and Gradante rendered the prior representations about the due diligence process materially misleading and breached their fiduciary duties to Hennessee Group’s clients.

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In the fall of 2002, Bayou refused to provide Hennessee Group with the prime brokerage reports that Hennessee Group had requested. However, instead of insisting that Bayou provide the reports as a condition of potentially being recommended, Hennessee Group proceeded to the next phases of due diligence. Gradante decided that a portfolio/trading analysis was irrelevant for a day-trading fund like Bayou, which stated in marketing materials that it held securities positions for brief periods of time and converted positions to cash prior to each day’s market closing.

As a result, Hennessee Group did not obtain or evaluate any quantitative information about Bayou’s portfolio characteristics, investment and trading strategies, or risk management discipline. Instead of confirming Bayou’s results and processes through an analysis of Bayou’s historical trading data to determine whether the fund was, in fact, executing its purported “high-velocity” day-trading strategy and utilizing appropriate risk management techniques, Gradante and Hennessee Group relied entirely on Bayou’s uncorroborated representations and purported rates of return that Bayou had provided during its initial information-gathering phases.

Hennessee Group never told the clients to whom it recommended Bayou that it had not conducted a portfolio/trading analysis on the funds. By failing to disclose this information in connection with its recommendation of Bayou, Hennessee Group left those clients with the misleading impression that it had conducted a portfolio, trading, and risk management evaluation of Bayou and that Bayou had satisfied Hennessee Group’s purported standards. In so doing, Hennessee Group and Gradante breached their fiduciary duties to Hennessee Group’s clients.

I have written a number of posts about proper hedge fund due diligence and am always surprised how haphazardly investments are made into some hedge funds. Over the past six to eight months I have also been surprised that so many sophisticated and savvy investors would be duped by frauds like Madoff… but I guess if those gatekeepers who are paid to help investors research managers are asleep at the wheel we can’t really expect much more from investors.

Please contact us if you have a question on this issue or if you would like to start a hedge fund. If you would like more information, please see our articles on starting a hedge fund. Other related hedge fund law articles include:

Washington, D.C., April 22, 2009 — The Securities and Exchange Commission today charged New York-based investment adviser Hennessee Group LLC and its principal Charles J. Gradante with securities law violations for failing to perform their advertised review and analysis before recommending that their clients invest in the Bayou hedge funds that were later discovered to be a fraud.

In a settled administrative proceeding, the Commission issued an order finding that Hennessee Group and Gradante did not perform key elements of the due diligence that they had represented they would conduct prior to recommending investments in the Bayou hedge funds. The SEC also finds that they failed to conduct a reasonable investigation into red flags concerning Bayou. Hennessee Group and Gradante routinely represented to clients and prospective clients that they would not recommend investments in hedge funds that did not satisfy all phases of their due diligence evaluation.

“Forewarned is forearmed — investment advisers must make good on their promises or face the consequences of vigorous SEC enforcement action,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

“As the Commission found, these investment advisers failed to honor the representations they made to their clients and did not disclose these material departures from their advertised services,” said Antonia Chion, Associate Director of the SEC’s Division of Enforcement. “The advice that clients receive from hedge fund consultants is especially critical when the hedge funds are neither regulated nor transparent.”

According to the Commission’s order, approximately 40 clients invested millions of dollars in the Bayou hedge funds from February 2003 through August 2005 after the Hennessee Group recommended those investments. Most of the money was lost through trading or dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements and year-end financial statements. The SEC charged the managers of the Bayou hedge funds with fraud in 2005.

The Commission’s order finds that Hennessee Group and Gradante failed to conduct the portfolio and trading analysis that it had advertised to clients. Instead of analyzing Bayou’s results and processes through a review of Bayou’s historical trading methods to determine whether the fund was, in fact, successfully executing its purported day-trading strategy, Hennessee Group and Gradante decided not to perform any analysis after Bayou refused to produce its trading data. They relied entirely on Bayou’s uncorroborated representations about its strategy and its purported rates of return.

The Commission’s order also finds that despite conflicting reports from Bayou about the identity of their independent auditor, Hennessee Group and Gradante failed to verify Bayou’s relationship with its auditor. In fact, the accounting firm that purportedly conducted Bayou’s annual audit was a non-existent entity fabricated by one of Bayou’s principals, who was identified in publicly available state accountancy board records as the registered agent for the bogus accounting firm.

According to the Commission’s order, Hennessee Group and Gradante also failed to respond to red flags concerning Bayou that came to their attention while they were monitoring Bayou on behalf of their clients. In particular, they failed to inquire or investigate when Bayou provided contradictory responses regarding the identity of its auditor or to adequately inquire about a rumor that one of Bayou’s principals was affiliated with Bayou’s purported outside auditing firm.

The Commission’s order finds that Hennessee Group and Gradante violated Section 206(2) of the Advisers Act. The order requires Hennessee Group and Gradante to pay $814,644.12 in disgorgement and penalties, and to cease and desist from committing or causing further violations. The parties also are required to adopt policies to ensure adequate disclosures in the future and to provide copies of the Commission’s Order to all current and prospective clients for a period of two years.

Hennessee Group and Gradante consented to the entry of the Commission’s order without admitting or denying the findings.
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For more information, contact:
Antonia Chion
Associate Director, SEC’s Division of Enforcement
(202) 551-4842
Yuri B. Zelinsky
Assistant Director, SEC’s Division of Enforcement
(202) 551-4769